The Basics

What is the Forex market and how does it work?

The Foreign Exchange (Forex) market is where most of the world’s currencies are traded. It is very important for people and businesses alike as they need to pay for goods and services in different countries and currencies. In order for this to occur, the person or business would need to sell their own currency in order to buy currency of the local country. For example, if you were a British company or person wanting to buy some Italian wine, the price for the wine would be listed in Euros (EUR). As you are British, your local currency would be British Pounds Sterling (GBP). Therefore, you would need to sell GBP and buy EUR so that you are able to purchase the wine. The rate at which you sell your GBP to buy EUR is called the exchange rate.

The need to do all these currency exchanges is the primary reason why the Forex market is the largest and most liquid financial market in the world. It dwarfs all other markets with an average daily traded value of around USD $4.9 trillion* (that’s 12 zeros!). Please note that this figure changes all the time and is only an average figure.

*Source: Bank for International Settlements (BIS) August 2012

A very interesting structural aspect of the forex market is that there is no central exchange or market for trading to occur. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralised exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centres of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the Forex market begins again in Tokyo and Hong Kong. As such, the Forex market can be extremely active any time of the day, with price quotes changing constantly.

What is the spot market?

The spot market is where currencies are traded based on their current price. The price is determined by supply and demand and is a reflection of many factors, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another.

USDJPY SPOT CHART (see below)

When a deal is finalised, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counterparty and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement once the deal has been finalised.

Understanding an exchange rate

When an exchange rate is quoted, it is always a figure which is quoted against another currency. If we are a British company looking to buy some Italian wine, we would be looking at the GBP/EUR rate. This would be quoted as follows:

GBP/EUR 1.1724

As we are looking from a GBP point of view, we see that £100 (the “base currency”) would equal EUR 117.24 (the “quoted currency”). Therefore, if the wine in question cost EUR 117.24 from the Italian wine company, the purchaser would need to sell GBP 100 in order to get EUR 117.24.

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). YOu will see it quoted like this:

The first referenced currency here “EUR” is the base currency and USD is the quoted currency. What this quote means is that you will have to spend US $1.28326 to buy one euro (this is the Ask Price) but if you sell 1 euro you will only receive 1.28284 worth of US dollars (the Bid Price).

Alternatively expressed, when buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency.

Spreads and Pips

The difference between the bid price and the ask price is called a spread. If we were to look at the above quote we used as an example: EUR/USD = 1.28284/326, the spread would be 0.00042 or 4.2 pips also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of pounds being made or lost due to leverage. Again, the ability to earn profit (or make a loss!) from even the tiniest price movement attracts traders to this fast paced market.

In the case of the U.S. dollar, euro, British pound or Swiss franc, the number of pips is determined by reference to the number at the 4th decimal place, and as such, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a Forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 80 to 150 pips a day.

The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout the day. For traders who may have a day job or just a busy schedule, it can be an optimal market to trade in. As you can see from the chart below, the major trading hubs are spread throughout many different time zones, eliminating the need to wait for an opening or closing bell. As the U.S. trading closes, other markets in Australasia are opening, making it possible to trade at any time during the day.

Time Zone

Time (GMT)

Tokyo Open

12:00am

Tokyo Close

9:00 am

London Open

8:00 am

London Close

5:00 pm

New York Open

1:00 pm

New York Close

10:00 pm

How do you determine the size of a trade?

The size of trade is determined by its notional amount. A common way to measure the transaction size is called a “a lot”. A lot is a transaction with a size of US$ 100,000.
If you buy EURUSD 1 lot or 0.1 million/ U.S.$100,000 transaction size and your Account Base Currency is sterling, this means that each pip move in the currency pair is worth approximately £6.70 at current levels. Correspondingly, if you trade a $1 million, your pip value is £67.00, meaning, that each 1 pip move of the EURUSD will be a £67 profit or loss to you. If you place a stop loss 10 pips away from your entry point, your maximum risk in this example is £670. On the flipside, if you target a 30 pip target, your potential profit is £2,010.

Atom8 will shortly provide you with an exceptional Forex Calculator to help you determine your pip value for any given transaction notional size you trade at the press of a button.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 57% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. You should make sure you understand the risks involved, seeking independent advice, if necessary.

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